The Efficient Market Hypothesis (EMH) and Forex

What is the Efficient Market Hypothesis?

The Efficient Market Hypothesis (EMH) states that financial markets are informationally efficient, which means that investors and traders will not be able to consistently make greater than market average returns. To put it simply, the EMH states that it is not possible to beat the market over the long run. Supporters of the theory hold that those who do in fact make more than average returns do so because they have access to inside information or alternatively have simply enjoyed a prolonged lucky streak. The modern form of the Efficient Market Hypothesis was developed Professor Eugene Fama of the University of Chicago during the mid 1960’s and was widely accepted within academia until the 1990’s when work in behavioural finance began to bring the hypothesis into question. Despite this many academics and some in finance hold the efficient market hypothesis to be true to this day.

Those who support the EMH typically layout their claims in one of three mains forms, with each form of the claim having slightly different implications.

Weak Form Efficiency: In this formulation of the EMH, future market prices cannot be predicted by simply analysing past price performance. It is therefore impossible to beat the market in the long run by using investment or trading strategies which rely on historical data. While the use of technical analysis may not allow traders to beat the market in the long run, some forms of fundamental analysis may allow for market participants to beat the market. This form of the hypothesis, holds that future price movements are determined by information which is not contained in past and current market prices, essentially ruling out the use of technical analysis.

Semi Strong Form Efficiency: This formulation of the EMH, goes quite a bit further than it’s Weak Form cousin. Holding that market prices rapidly adjust to any new and publicly available information, this rules out both technical and fundamental analysis. Only those with access to inside information would be able to beat the market in the long run.

Strong Form Efficiency: Those who believe in the strongest form of the EMH believe that current market prices reflect all public and private information meaning that no one can beat the market, even those with insider information. It might seem that this version of the efficient market hypothesis can be easily refuted, as there are a considerable number of money managers who have been able to beat the market year after year. Those who support this hard line version of the EMH, often respond by pointing out that with the sheer number of people who actively trade the financial markets you will expect some to get lucky and make impressive returns year after year.

Criticism of the EMH and Behavioural finance

Investors and increasingly those in academia have been very critical of the Efficient Market Hypothesis, questioning the hypothesis on both theoretical and empirical grounds. Behavioural economists have pointed to numerous market inefficiencies, which can often be attributed to certain cognitive biases and predictable errors in human behaviour. The rise of algorithmic trading and quantitative finance hasn’t necessarily rid the financial markets from such cognitive biases, with the 2008 financial crisis demonstrating how cognitive biases can work there way into complicated quantitative models. In fact some have gone as far to suggest that the EMH was partly responsible for the 2007-2012 financial crisis, with the hypothesis causing financial and political leaders to have a “chronic underestimation of the dangers of asset bubbles breaking”. Much of the work of behavioural economists suggests that we have good reason to reject both the Strong and Semi-Strong versions of the efficient market hypothesis.

Are the Forex markets an example of an efficient market?

The majority of the research into the efficient market hypothesis has focused on Stock Markets, but there have been a number of researchers who have looked into whether the Forex markets are informationally efficient. A study published in 2008 by J.Nyugen of the University of Wollongong looking at 19 years of data found that it was possible to create trading rules which could deliver significant returns indicating that the FX markets may be inefficient. Though the study went onto say that the trading rules only delivered significant returns during the first five year period, suggesting that either the FX markets became more efficient during the time period or simply the trading rules created by the studies authors broke down. Another 2008 study, found that it was possible to predict movements in price using only statistical data, however it wouldn’t have been profitable to have traded the markets using the studies predictive model. These studies suggest that the FX markets are somewhat efficient but they certainly don’t demonstrate that it is impossible to consistently turn a profit trading Spot FX.

Conclusion

The Efficient Market Hypothesis (EMH) was extremely popular among those in academia during the late 20th Century, however many of those active in finance were never convinced by the EMH. During the 90’s, the hypothesis began to lose credibility with many behavioural economists beginning to seriously undermine the hypothesis. When it comes to the question of whether the Spot FX markets are efficient as defined by one of the forms of the EMH, there is simply not enough research to make any sort of conclusive statement. The data shows that it is possible to create rules and trading strategies which allow one to predict market movements with a significant degree of accuracy. The strategies in these studies struggled in regards to profitability, but this may only hint at the FX markets displaying some weak form efficiency under certain circumstances.